RDP 7702: Inflation and Economic Stability in a Small Open Economy: A Systems Approach 2. Recent Australian Experience: An Overview

In the first half of the 1970's, a variety of impulses came together to generate the third major acceleration of prices of the century; from 1969/70 to 1975/76 price rises averaged around 11%,^[1] which compares with just on 3% during the decade of the 1960's. As indicated in table 1, inflation, as measured by the GDP deflator, accelerated to a peak of around 17.5% per annum in 1974/75 and then declined somewhat.^[2] Wage rises on average exceeded price rises by more than can be explained by rises in productivity, resulting in an increase in the share of wages in GDP from an average of .51 in the 1960's to .59 in 1974/75. A major determinant of this higher share was a series of strong increases in arbitrated award wages, which in 1970/71 rose by 11.5%, in a year in which prices increased by 5.3%, and in both 1973/74 and 1974/75 by around 24%, also substantially in excess of price rises.^[3]

The prices of traded goods, as represented by the export and import price deflators, were on average almost stable through the 1960's, and rose relatively little until 1972/73 in the case of export prices and 1973/4 in the case of import prices, then increased strongly in line with the worldwide explosion in the price of traded goods, particularly primary commodities. Australia's exchange rate with the US$ remained fixed throughout the 1960's then revalued substantially from 1971 to 1973 and subsequently devalued.^[4] The relatively slow growth of Australian prices, and particularly export prices, combined with the effects of major mineral discoveries to produce high export growth. This contributed to strong growth of output, and an intense domestic boom in 1973/74.

The large trade surplus was reinforced by large capital inflows to produce increases in international reserves which reached a peak year on year rise of 68% in 1971/72. Despite this, monetary growth (represented by growth in M3) remained below its average for the 1960's of slightly less than 8% per annum until 1971/72, when it reached 10.5%. The low rates of domestic credit expansion of the early 1970's resulted from relatively low rates of growth of government spending on goods and services, fiscal drag, and quite large non-bank take-up of government securities in 1971/72, reflecting the effects of traditional stabilization policy responses to the rising inflation. In 1972, however, budgetary policy was relaxed somewhat, and combined with an explosion of bank lending in 1973 to generate an enormous expansion of domestic credit. This was reinforced by a 30% increase in international reserves^[5] to raise the money stock by 26% in 1972/73. In subsequent years rapid domestic credit expansion continued, fuelled by fast growth in government outlays,^[6] although falling international reserves helped restrain average growth in money supply to rates around 15%.^[7]

An indication of the degree to which inflation has become entrenched is provided by an index of price expectations constructed from a survey of manufacturers;^[8] this measure suggests that while in the June quarter of 1972 manufacturers expected price increases at an annual rate of approximately 8%, this has risen to 14% by June 1973, 18% by June 1974, 16% by June 1975 and 16% by June 1976.

The greatly increased inflation has been accompanied, as in other countries, by low growth of real product and increased unemployment. As table 1 indicates, the unemployment rate was about three times its average value for the 1960's in 1975/76; and growth in real product was negative in 1974/75 and relatively small in 1975/76.^[9]

The recent performance of the Australian economy is put into a slightly broader perspective in figure 1, which presents average rates of inflation and unemployment since 1948. After the first seven years, which were strongly influenced by the economic instability of the Korean war years, the apparent “trade-off” between inflation and unemployment was very stable for Australia. For 1971 to 1975, however, both inflation and unemployment are considerably higher, as in many other countries in recent years.^[10]